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Credit Spreads with Dynamic Debt

Associate Professor Seoyoung Kim, Santa Clara University California USA

3rd May 2013  11:30 am - 12:30 pm Room 214/215 H69

Abstract: We provide a framework to analyze debt where there is a latent option to alter the underlyingprincipal. Specifically, we extend the Merton (1974) model for static debt guarantees in a setting with dynamic debt, where leverage can be ratcheted up as well as written down through pre-specified policies. We show that for many dynamic debt covenants, ex-antecredit spread term structures may be derived in closed-form using modified barrier optionmathematics, a class of exotic derivatives that are activated or de-activated upon accessing a pre-determined barrier. We observe that principal write-down covenants decrease the magnitude of credit spreads but increase the slope of the credit curve, transforming downward sloping curves into upward sloping ones. On the other hand, ratchet covenants increase the magnitude of ex-ante spreads without dramatically altering the slope of the credit curve. Overall, explicitly modeling this latent option to alter debt leads to term structures of credit spreads that are more consistent with observed empirics.


Friday 3rd May 2013
11.30am - 12.30pm
Room 214/215 Economics and Business Building

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